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Argentina’s Rational Default

A man at a demonstration, in Buenos Aires, on July 30th, holds up a sign reading “Homeland or Vultures.”Credit Photograph by Marcos Brindicci/Reuters.

Argentina has long been guilty of fiscal mismanagement: it first reneged on a government bond in 1828, and it has bilked its lenders repeatedly ever since. In recent years, the populist government of President Cristina Fernández de Kirchner has reinforced this reputation by doctoring inflation statistics, expropriating pension funds and an oil company, and blocking Argentines from buying foreign currency. So when Argentina defaulted on its public debt, last week, the familiar narrative about Latin America’s leading basket case proved irresistible to the global financial press. “The problem is of Argentina’s own making,” Daniel Fisher wrote on Forbes’s Web site.

For decades, Argentina has blamed rapacious foreign financiers for its self-inflicted wounds. But this time, its victim complex is justified. Forced to choose between highly unpalatable options, President Fernández was probably right to default. And it is Washington, not Buenos Aires, that is most capable of resolving the latest financial impasse.

This default, Argentina’s eighth, is perhaps the strangest in history. The government has plenty of cash on hand and has already deposited its most recent interest payment—of five hundred and thirty-nine million dollars—with its trustee, the Bank of New York Mellon. But the bank cannot forward Argentina’s money to its creditors, because Thomas Griesa, a federal judge in New York, has issued an order prohibiting the transfer.

Thirteen years ago, Argentina underwent what was then the biggest sovereign default in history. Afterward, unemployment rose to twenty-five per cent. The cartoneros—armies of the jobless who fanned out to collect cardboard and scrap metal for resale—temporarily replaced Carlos Gardel, Evita, and Maradona as the emblematic Argentines of popular imagination.

In 2003, in the first Presidential election following the crisis, voters opted for Néstor Kirchner, a little-known governor from Patagonia. One of Kirchner’s first tasks was to address the country’s huge debt burden. Argentina’s economy had just begun to recover, and the government could ill afford to satisfy its foreign creditors. So, in 2005, the Kirchner Administration made a take-it-or-leave-it offer: Argentina would issue its lenders new debt, valued at sixty-five per cent less than the old bonds. The holders of three-quarters of the defaulted bonds accepted the exchange, but the remainder held out, hoping for better terms. In 2010, owners of another seventeen per cent of the original debt accepted another, similar offer. That left just eight per cent outstanding. Most of this sliver belonged to firms known, unflatteringly, as “vulture” investors, who specialize in buying distressed bonds on the cheap and suing for full payment. Among them was the hedge fund Elliott Management Corporation.

The system in the United States for dealing with corporate bankruptcies is impressively efficient. When a company goes under, a judge evaluates its capacity to pay, and can force the firm and its creditors to reach a settlement. Unfortunately, there is no analogous process for foreign governments, both because countries never really go bankrupt—they can always tax their citizens more—and because they are generally immune from other nations’ legal proceedings. They don’t call it sovereign debt for nothing.

Governments can choose to surrender this immunity in order to issue debt abroad. When countries borrow under their own law, nothing can stop them from rewriting contracts with their creditors, later on, to reduce what they owe. Lenders typically demand higher interest rates to compensate for this risk. Countries that want cheaper financing can sell debt under foreign law, which requires them to abide by the contract’s original terms. In 1976, Congress passed the Foreign Sovereign Immunities Act (F.S.I.A.), which allowed governments with commercial involvement in the United States to be sued. In theory, the law gave lenders the right to enforce their claims against government debtors just as they would against companies. It failed, however, to provide any mechanism by which American courts could force other countries to comply with their rulings.

The legal battle between Elliott and Argentina has brought this weakness into high relief. The fund bought defaulted Argentine debt issued under New York law. After rejecting the country’s bond-swap proposal, in 2005, it secured repeated orders from Griesa requiring Argentina to pay the full face value of the plaintiffs’ debt plus all past-due interest, a sum that is now approaching one and a half billion dollars. Argentina disregarded the rulings.

Over the years, Griesa has grown increasingly frustrated with Argentina’s intransigence. In 2012, he implemented a new method of forcing the country to pay up. Although the government’s assets lay outside of his jurisdiction, Griesa did have authority over the banks that processed the payments. Citing the bond contracts’ guarantee of pari passu, or equal treatment, he ruled that Argentina was illegally discriminating among its creditors by staying current on the debt from the 2005 and 2010 bond exchanges while stiffing the holdouts. (Jonathan Blitzer wrote about the case for this magazine.) As a result, Griesa prohibited the Bank of New York Mellon from releasing any of Argentina’s interest payments unless the country paid Elliott’s claim, too. Argentina appealed to the U.S. Supreme Court, but, in June, the Court declined to hear the case, letting Griesa’s decision stand. This left Argentina with an unenviable choice: either surrender to the holdouts, or reënter default.

The holdouts’ lobbyists, led by a trio of former Clinton Administration officials, have been quick to tout the findings of economists who havewarned that a new default would cause a collapse in foreign investment, a flight from Argentina’s currency, and a prolonged recession. As journalists repeated these doomsday predictions, the market price of defaulted Argentine bonds soared, presumably based on hopes that the government would pay up at last rather than commit what sounded like economic suicide.

In Argentina’s unique situation, though, the prospect of returning to default wasn’t much of a threat. The primary reason that states honor their debts is so that they can keep borrowing. But Argentina hasn’t enjoyed this luxury for a long time. The threat of litigation from Elliott has prevented the country from selling bonds abroad since 2001, even though the holders of ninety-two per cent of its defaulted debt accepted its exchange.

As for the supposed economic side effects of default, the government’s generally disastrous domestic policies have already scared off investors and lenders. It’s hard to imagine a company that would otherwise have built a factory in Argentina cancelling the project because a judge in New York is blocking the government’s foreign-debt payments. To be sure, businesses that rely on short-term financing for international trade will have more difficulty obtaining credit, as will firms, like the national oil company, that want to raise capital. But if the default really presaged economic collapse, the Buenos Aires stock market would have crashed in response. Instead, the index is within seven per cent of its record high.

The holdouts’ fallback argument was that, even if default was a toothless threat, Argentina would still benefit from making amends with the markets. This is undoubtedly true, but the gains would probably be modest. Argentina can already sell dollar-denominated bonds under its own law, as it did in the years following the first restructuring, when it issued eight and a half billion dollars’ worth. A deal with Elliott would simply let the country borrow abroad instead, an advantage that would likely reduce Argentina’s interest rate by a few percentage points at best.

The cost of securing this slightly cheaper financing would be steep. To avoid copycat litigation from other creditors, the government would need to extend the terms of any settlement to all of the other holdouts. That would cost around thirteen billion dollars, nearly half of the country’s dwindling foreign-currency reserves. Any such deal could, in turn, trigger a new wave of lawsuits from investors who accepted the earlier restructuring, since their contracts guarantee the right to participate in any subsequent debt exchange voluntarily offered by Argentina before 2015. The holdouts argue that Argentina could fend off these cases. But as Griesa’s own rulings demonstrate, legal outcomes are exceedingly hard to predict. Given this risk-reward trade-off, deciding to default—or #GrieFault, as it’s been dubbed on Twitter—probably qualifies as one of the few wise economic decisions that President Fernández, Kirchner’s widow and successor, has made.

The credit-rating agency Standard & Poor’s officially declared Argentina in default on July 30th, when the monthlong grace period following its missed interest payment expired. On the streets of Buenos Aires, the following day, there was little to report. “It’s July 31st, and the world’s still spinning . . . life goes on,” Fernández said. By contrast, in New York, the consequences of the default are just becoming clear. Holders of the restructured bonds are out five hundred and thirty-nine million dollars and counting, as the Bank of New York Mellon has gotten caught in the crossfire between Argentina and Elliott.

In the course of this fight, the reputation of the United States as a reliable financial center has been damaged. According to a report from the International Monetary Fund, around a hundred billion dollars of sovereign bonds sold under New York law could conceivably be vulnerable to a legal attack like the one on Argentina. Whenever one of these issuers defaults, a single creditor might now be able to stop everyone else from getting paid unless it receives a hundred per cent of what it is owed. As a result, all creditors should be expected to hold out and demand full repayment. That could make it impossible for governments to restructure their debt and escape default.

Elliott and the other holdouts insist that Argentina can resolve the situation by paying up. In the short run, a better solution would be for the U.S. Congress to end the default by passing a law guaranteeing the safe delivery of sovereign-debt payments to their destinations—including when countries can’t repay all of their creditors at once. But even that fix would leave the root cause of this sordid situation unaddressed: the myth at the heart of the F.S.I.A. itself. On paper, the law lets foreign countries act almost like corporate borrowers when they sell debt under American jurisdiction. But in practice, the situation is more complicated. In June, the Supreme Court tried to bolster the F.S.I.A. by allowing Elliott to use judicial subpoenas to search for Argentine government funds around the globe. But this power does not alter the fact that sovereign property, unlike a company’s assets, can rarely, if ever, be seized. Embassies and military equipment are shielded by treaties, central-bank reserves are stored in safe havens, and sending gunboats to extract interest payments—a favored collection method in the past—has fallen out of fashion. The illusion of enforceable foreign-law government debt has real costs: it leads gullible investors to accept insufficient interest rates, and allows sovereign borrowers to weaken our perception of the rule of law by refusing to comply with American court orders.

The only way America can effectively protect its investors and defend the authority of its courts is to reconcile the F.S.I.A. with the reality that governments always retain their immunity, no matter what the law says. One possible solution might be for foreign countries that want to borrow in the United States to post collateral under American jurisdiction—for instance, by storing part of their foreign-currency reserves at a U.S. bank. Governments that are unwilling to grant this security to investors would then have to borrow under their own law instead. The resulting transparency would provide the most reliable way possible for creditors to defend their interests: charging enough interest to compensate for the risk.

Dan Rosenheck is a staff writer and former Argentina correspondent for The Economist.